DP15488 Public Debt as Private Liquidity: Optimal Policy

Author(s): George-Marios Angeletos, Fabrice Collard, Harris Dellas
Publication Date: November 2020
Keyword(s): optimal policy, piblic debt, private liquidity
JEL(s): E62
Programme Areas: Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15488

We study optimal policy in an economy in which public debt is used as collateral or liquidity buffer. Issuing more public debt raises welfare by easing the underlying financial friction; but this easing lowers the liquidity premium and increases the government's cost of borrowing. These considerations, which are absent in the basic Ramsey paradigm, help pin down a unique, long-run level of public debt. They require a front-loaded tax response to government-spending shocks, instead of tax smoothing. And they explain why a financial recession, more than a traditional one, makes government borrowing cheaper, optimally supporting larger fiscal stimuli.